Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionIII. Valuation of Future
Cash Flows- Interest Rates and Bond
Valuation
(^248) © The McGraw−Hill
Companies, 2002
lot of reasons, but Moody’s was particularly concerned about a general downturn in the
telecommunications supply business along with a potential cash crunch at Lucent.
Credit ratings are important because defaults really do occur, and, when they do, in-
vestors can lose heavily. For example, in 2000, AmeriServe Food Distribution, Inc.,
which supplied restaurants such as Burger King with everything from burgers to give-
away toys, defaulted on $200 million in junk bonds. After the default, the bonds traded
at just 18 cents on the dollar, leaving investors with a loss of more than $160 million.
Even worse in AmeriServe’s case, the bonds had been issued only four months ear-
lier, thereby making AmeriServe an NCAA champion. While that might be a good thing
for a college basketball team such as the University of Kentucky Wildcats, in the bond
market it means “No Coupon At All,” and it’s not a good thing for investors.
SOME DIFFERENT TYPES OF BONDS
Thus far, we have considered only “plain vanilla” corporate bonds. In this section, we
briefly look at bonds issued by governments and also at bonds with unusual features.
Government Bonds
The biggest borrower in the world—by a wide margin—is everybody’s favorite family
member, Uncle Sam. In 2001, the total debt of the U.S. government was $5.6 trillion,or
about $20,000 per citizen. When the government wishes to borrow money for more than
one year, it sells what are known as Treasury notes and bonds to the public (in fact, it
does so every month). Currently, Treasury notes and bonds have original maturities
ranging from 2 to 30 years.
Most U.S. Treasury issues are just ordinary coupon bonds. Some older issues are
callable, and a very few have some unusual features. There are two important things to
keep in mind, however. First, U.S. Treasury issues, unlike essentially all other bonds,
have no default risk because (we hope) the Treasury can always come up with the
money to make the payments. Second, Treasury issues are exempt from state income
taxes (though not federal income taxes). In other words, the coupons you receive on a
Treasury note or bond are only taxed at the federal level.
State and local governments also borrow money by selling notes and bonds. Such is-
sues are called municipalnotes and bonds, or just “munis.” Unlike Treasury issues, mu-
nis have varying degrees of default risk, and, in fact, they are rated much like corporate
issues. Also, they are almost always callable. The most intriguing thing about munis is
that their coupons are exempt from federal income taxes (though not state income
taxes), which makes them very attractive to high-income, high–tax bracket investors.
Because of the enormous tax break they receive, the yields on municipal bonds are
much lower than the yields on taxable bonds. For example, in May 2001, long-term Aa-
rated corporate bonds were yielding about 6.72 percent. At the same time, long-term Aa
munis were yielding about 4.87 percent. Suppose an investor was in a 30 percent tax
CONCEPT QUESTIONS
7.3a What is a junk bond?
7.3bWhat does a bond rating say about the risk of fluctuations in a bond’s value re-
sulting from interest rate changes?
218 PART THREE Valuation of Future Cash Flows
7.4
If you’re nervous about
the level of debt piled up
by the U.S. government,
don’tgo to http://www.public
debt.treas.gov, or to http://www.
brillig.com/debt_clock!
Learn all about
government bonds
at http://www.ny.frb.org.